Category Archives: Startups

Venture capital’s new normal

In many ways, 2010 was an incredibly surprising year for the VC industry. The pace of investment activity picked up considerably following the economic turmoil in 2008 and 2009. The number of companies started, investment valuations and the speed at which financings were completed all increased dramatically relative to the prior two years. At the same time, the long awaited restructuring of the VC industry started to become reality with fewer traditional funds being raised, more small (angel and micro-VC) funds launching and many VCs leaving the industry for other careers. Finally, the M&A market picked up and the IPO market cracked open a bit, creating more liquidity than the past couple of years.

2011’s even faster start has surprised not only many outside of the VC industry, but also many VC professionals. There has been extensive commentary on what is perceived to be an overheated or irrationally exuberant market, but I believe that we are simply experiencing the “new normal”, at least for the next few years. The reality is that there remains too much investment capital in pursuit of funding the handful of companies started each year that will generate outsized returns for limited partners. VC industry returns have been abysmal for the past decade, so missing out on those winners could mean the inability to raise new funds for many firms. At the same time, the cost of starting companies is lower than ever and angels and funds of all sizes are competing to finance the same, increasingly capital efficient businesses. More sources of abundant capital mean more companies being started and increasingly low odds of predicting which companies will emerge as winners. All of this creates a dynamic in which the first inkling of success for a young company yields multi-million dollar financing offers at seemingly inexplicable valuations ($100 million has become the new $10 million) and proven success generates multi-hundred million dollars financings at unprecedented valuations.

Unfortunately, this is likely to be the difficult reality of the VC industry for at least the next few years. For now, this new normal seems to be limited to the private investing market, not the public market, suggesting that this is not a bubble like the one experienced a decade ago. Further, in the VC market, dollars invested today don’t prove themselves to be ill spent for several years down the road. The repercussions of poor investing take even longer to unfold. The new normal in the private market will not quickly disappear with the bursting of a bubble, but rather slowly give way like an aging balloon bleeding air.

While many VCs will lose playing this new game, the good news is that there has never been a better time to be an entrepreneur, or in all likelihood, a consumer. Capital is freely and cheaply available to those willing to accept the startup challenge, both here in the US and around the globe. The startups that do emerge from the current financing frenzy as market leaders will have created innovative products and services for which consumers will be the ultimate beneficiaries. Those entrepreneurs will have created enormous wealth for themselves. The VCs that supported those entrepreneurs may or may not have generated returns for their investors. Which would you bet on?

4 sources of long term differentiation and competitive advantage

Despite the slowdown in venture investing during most of last year, it seems like venture activity picked up significantly in Q4. The data is consistent with my own experience during the quarter, where I saw a huge increase in companies seeking financing, the return of multiple competitors for every investment opportunity and incredibly compressed fundraising processes. I fear that we’re returning to an investing and startup environment much like the one prior to October 2008. One impact of this behavior is that we’ll likely see, as before, the funding of many companies in the same market or with similar offerings (many people point to location-based social networking companies such as Foursquare, Gowalla, Booyah, etc. as a good example). That’s led me to try to outline what I think are the only ways for web technology companies to truly have long term differentiation. Clearly, with time and money, talented people render most software and user experiences alone indefensible. So how do Internet and digital media companies create sustainable competitive advantage? 

Network effects: Businesses with network effects have products or services that increase in value as more customers use them. When a network effects business achieves scale, it can have incredibly lasting differentiation because recreating that network poses significant challenges to competitors. Microsoft Office, eBay and Yelp are good examples of these types of products and services. Some network effects businesses can have both positive and negative network effects. For example, as many social media businesses grow in use, the volume of content to filter and absorb can become overwhelming.

Switching costs: Products or services that make it difficult or expensive to use an alternative product or service have switching costs. Creating this kind of lock-in is a true barrier for competition. DoubleClick’s DFA product is a great example of a product that had tremendous value because it was embedded in the agency online media buying process and was used by many people within agencies.

Scale: For a product or service, differentiation can be derived from scale in customer usage, capital expenditure or data. As an example, Google enjoys incredible differentiation and competitive advantage from all three sources. Hundreds of millions of people conduct billions of searches on Google each day, leading websites that want to integrate search to turn to the de facto standard in the industry. Google has spent untold sums of money on hundreds of thousands of machines in datacenters around the world to deliver the fastest, freshest and most relevant search results to its users. The hundreds of millions of clicks generated each day on search results provide Google with a vast quantity of data and insights that help improve search quality. Any new search competitor not only has to deliver a superior consumer search experience, but it also has to spend enormous amounts of money recreating the underlying infrastructure and data that makes Google such a powerful competitive force.

Culture/People: Given that web technology itself is largely indefensible, the greatest source of differentiation and competitive advantage is often execution, and that is predicated on people and the culture in which they operate. Whether it’s the culture of innovation at Google, the culture of customer happiness at Zappos or the culture of freedom and responsibility at Netflix, I’m certain that the management teams from those companies would point to the employees and the DNA of the organizations as the primary reasons for their success. I find that when the culture of a company is well-defined, it is usually a direct reflection of the founder(s) and their conscious decision to establish a well-defined company culture from the start. I only know of a few instances where the culture of an organization was either instilled in the organization at a later point in the company’s development or successfully recast by new leadership.

When choosing what investments to make, I try to keep these sources of differentiation top of mind. It’s easy to get caught up in the appeal of a sexy new consumer application or a seemingly novel approach to a business problem. But lasting, significant equity value is often only created when one or more of these differentiating factors are at play. Are there other sources of differentiation that you would add to the list?

11 tips for the VC pitch

A couple of weeks ago, I gave the presentation below to the companies participating in First Growth Venture Network. The focus of the day was how to pitch investors and while every investor has his or her preferences, I find that there is 80%-90% overlap in what most investors are hoping to see and hear. Given that there are so many great resources on this topic available on the web for entrepreneurs, I wanted to focus on a few key things that seem to get overlooked in advance of and during many pitches. This presentation is a bit incomplete without the accompanying commentary but hopefully you can get the key points and be somewhat entertained in the process (lots of cartoons!).


 
Here are a few, brief clarifying points:

Pursue feedback: Get feedback on the pitch from people that you trust and make sure you practice it in front of an actual audience. Use this opportunity to test all of your assumptions.

Don’t talk to strangers: Research the partner that you are meeting with, but more importantly, understand why that partner might be interested in what you are doing. Investors see hundreds of businesses each year and they say no to 99.5% of them. Investors are prolific “daters” but they need to feel chemistry to get “married”. I refer to this feeling as emotional resonance and I see very few investments made where that is missing.

Small bites, big appetite: All investors ask themselves whether the business they are seeing is a feature, a product or a company. As an entrepreneur, you need to be able to sell a vision while focusing on near term milestones. Start small and focused but have a plan to get big.

Any and all questions and feedback are more than welcome!

Tips for product management success

I work with several early stage companies that are spending all of their time and energy focused on building great products that address real customerpain. To me, this is the most exciting time in a startup’s development. Starting from a blank page and creating something that will hopefully be in the hands of many satisfied users is both an imposing and thrilling challenge. My product management experience has given me several key insights (I think!) into what contributes to the success of a product manager. I’ll share a couple of those thoughts below and hopefully publish additional ideas over time.

I don’t think that you can be truly successful as a product manager if you haven’t experienced the customer or user’s pain firsthand.  Being close to the customer can provide unique insight into product requirements, and even more importantly, can shed light on what is not required in the product at all. Often times, customers and users will say that they want X or Y feature, but that is only what they think they want. What they need is a specific problem to be solved. Having lived with that problem can provide a product manager with the insight required to identify a true solution. All customer and user feedback is not created equal and knowing which feedback to incorporate into product plans is a necessary skill for any product manager.

A successful product manager also knows that he or she is not an engineer. Trust the engineers to do what they do and involve them early and often in product thinking. If the product manager and the management team have hired strong developers, technical leads, etc., they will not only figure out how to build the product correctly but they will help make the end product markedly better. Many product managers don’t have the confidence in themselves or in engineering to avoid micro-managing and over-documenting. But I’ve found that allowing the engineering team members to own what they are expert in leads to greater confidence in the product manager, more collaborative teams and more efficient product development. It also just makes being a product manager a lot easier!

(Thanks to Hiten Shah from KISSmetrics for inspiring this post.)

Four essential characteristics of entrepreneurs

Despite the fact that my New York Giants failed to make a repeat trip to the Super Bowl, being the diehard football fan that I am, I wasn’t going to miss the Big Game. Whether or not it was the greatest Super Bowl of all time (it wasn’t), one thing that stood out to me was the way in which both teams rallied when they were down and how it took the effort of every player on each team to deliver success. It was clear that no individual player wanted to let down his team by not doing his individual job well.

It strikes me that we’re seeing the same thing play out in the world of startups right now. The companies that are continuing to make progress notwithstanding the challenges in the funding environment and the broader market are the ones with teams that are committed both to the mission of the company and to each other. I would argue that a quality team is the most important factor in the success of a startup, but never is the quality of a team more important than in a down market. After all, there are no unique ideas, only unique execution and execution is the difference between success and failure given the current economic situation.

So what are the characteristics of a successful entrepreneur or team?  I don’t know that I have the right answer to that question, but here are the things that I look for when making investments. First is passion. Is the team genuinely excited about the business and the problem that it is addressing? Is it committed to solving the problem and building a sustainable business? Passion is a requirement given that there are so many ups and downs in the life of a startup. Second is flexibility. Rarely is the initial approach to solving a problem or attacking a market the right approach. Entrepreneurs and teams that can’t react to messages from and changes in the market are likely to continue marching down a path that leads to a dead end. Third is expertise. It’s important to note that expertise isn’t defined as years of prior experience building a company or product. I deem expertise to be the possession of unique insight that sheds light on an acute pain and the salve for that pain. In other words, what is it that makes the team uniquely qualified to solve the problem that they have identified? Finally comes integrity. The relationship between an investor and a team of entrepreneurs is often compared to a marriage, and the comparison is only a slight exaggeration. Trust, honesty and candor are the foundations of the entrepreneur-investor relationship. Without those building blocks, the inevitable ups and downs of the corporate marriage are impossible to withstand.

While this isn’t a comprehensive list of what I believe makes an entrepreneur or team successful, these are some of the absolutely critical characteristics. And I would expect that any startup team should be looking for the same qualities in its investors. I’m blessed to work with a group of entrepreneurs whom I am proud to call both great partners and friends. I have absolute confidence that these teams will be able to execute well during the current economic downturn and emerge much stronger and better positioned than the competition. Watching the Super Bowl, it was clear that each player had the same faith in his teammates, even when it looked like the game was over. I hope that the same can be said about the Giants a year from now!

P.S. Many thanks to those of you who sent your thoughts and prayers my way upon hearing about the passing of my father-in-law. Supporting him and my family through his battle with cancer was a major reason that I’ve been remiss in blogging for so long.

If you build it, they might not come

A while back I wrote a piece for The Battery Charger, my firm’s quarterly newsletter, about our investment focus within the Internet and Digital Media sectors. As I noted in that article, we invest in both consumer-facing media properties and enabling technologies. In my meetings of late, I’ve noticed a disturbing trend amongst companies that belong to the first category. While almost all of the presenting media companies have slick demos and whiz-bang product features, very few of them have gone to the trouble of outlining their strategy for possibly the most important and difficult piece of building any successful media business: acquiring consumers.

 

As a VC, one of the fundamental questions I ask when meeting entrepreneurs is about the unit economics of their business. How much does it cost to acquire a consumer and what is the lifetime value of that consumer once you acquire him or her? Most thoughtful entrepreneurs have considered this issue and can offer an answer. However, when I ask what strategies they are using to acquire users at the cited costs, I’m surprised by how often the response I get is a simple statement about some combination of SEO, SEM and viral marketing. Without fail, the entrepreneurs cite examples of other products that have been built on largely word-of-mouth alone.

 

I would argue that the next level of detail is critical to a well-thought out strategy for user acquisition. What are the specific tools and techniques that will be used to improve and optimize your SEO and SEM results (e.g., avoid dynamic URLs, use descriptive page titles, etc.)? What other steps will you take to create awareness for your product or service (e.g., blogging, content syndication, email marketing, etc.)? Which aspects of your product encourage sharing and linking or generate network effects? Good investors or advisors will not only ask these questions but offer some tips and tactics or relevant contacts of their own. They’ll also look to understand the overall quality of the traffic that is being generated, seeking that coveted shift in traffic from paid sources and organic search to direct navigation. My rule of thumb is that 30% direct navigation indicates the beginnings of brand loyalty and that 50% is evidence of strong traffic quality.

 

Admittedly, tackling the problem of user acquisition is extremely challenging and complex. But that doesn’t mean that it should be ignored or given short shrift. There are many resources that can help identify best practices for various consumer acquisition strategies and tactics. For example, Google itself publishes some good SEO guidelines and other helpful hints can be found on SEOmoz.org and SEObook.com. However you identify the strategies or whatever the approaches you choose, the crucial thing to remember is that a good product typically isn’t good enough, especially if you’re competing against incumbent players. Investors are certainly aware of that fact and entrepreneurs should demonstrate that they are as well.

Scaling startups is more than technology

In the “Web 2.0” startups of today, innumerable technology choices are the topics of the day when talking about scaling the business. Countless hours and meetings are spent debating the virtues of Ruby on Rails, Amazon Web Services and server virtualization. A fortunate few companies find themselves in the enviable position of having to devote even more time and attention to even more critical, non-technical scaling challenges. When a startup delivers a product to market that fulfills a clear customer need, sometimes the biggest challenge can be addressing that demand with operational scale. In a market with so many startups and established companies competing for dollars, customers and talent, outstanding people and defined processes are vital to any business that is hoping to scale successfully. I encourage the teams that I work with that are lucky enough to be in this situation to answer two key questions to determine whether they are set up to scale effectively.

First, are there any single points of failure amongst your people and processes? A challenge with so many startups is that there a small handful of the oldest employees who have the majority of the business, technical and product knowledge contained within themselves. Pitching the product clearly, implementing customers or addressing bugs can all be bottlenecks to success if only a single expert can manage those tasks. Systematizing the dissemination of knowledge through various media, and importantly, through person-to-person guidance, is as important to scaling a business as documenting code is to scaling an engineering team. Further, even if several people have the ability to execute as needed, without clearly defined processes, those people may be ineffective, inefficient and demoralized. That is not to say that bureaucracy and rigid rules are needed to scale a business. On the contrary, a process that is both flexible and regularly modified based on business needs can aid in delivering consistently good performance.

Second, are you hiring and transferring knowledge to make yourself obsolete? The first step is being disciplined about hiring only the best people for your organization. That doesn’t mean that you are hiring the smartest, the most educated or the most accomplished people. Instead, the goal is to hire people who have the skills and the values needed to be successful within your organization. I hesitate to use a term as soft as “values”, but the importance of a shared culture, commitment and vision can’t be overemphasized during the development of a young company. If you are successful in making yourself obsolete, not only have you hired great people, you’ve supplied them with the tools, knowledge and processes needed to do their job (previously yours) consistently well. 

So is your organization built to scale? If you’re lucky, you’ll get to find out, because the opposite of scaling isn’t nearly as fun or rewarding!